Wall Street Banks Hit by Oil & Gas Defaults, Bankruptcies

The fracking boom has been cash-flow negative for oil and gas drillers from the very beginning. The steep decline rates of fracked wells force producers to drill more wells just to keep production and revenues flat, even at high oil prices. They fund this drilling with debt. To show revenue growth, drillers have to get on an ever faster-moving treadmill of more production and more debt. To support that growing debt, they have to produce more and take on even more debt. They can never get off that treadmill. And their suppliers are on the treadmill with them.

This worked as long as the Fed’s interest-rate repression blinded investors to risk, made them desperate for yield, and encouraged them to sink ever more money into the industry.

It suited Wall Street just fine: according to Dealogic, banks extracted $31 billion in fees from the US oil and gas industry and its investors over the past five years by handling IPOs, spin-offs, “leveraged-loan” transactions, the sale of bonds and junk bonds, and M&A.

That’s $6 billion in fees per year! Over the last four years, these banks made over $4 billion in fees on just “leveraged loans.” These loans to over-indebted, junk-rated companies soared from about $40 billion in 2009 to $210 billion in 2014 before it came to a screeching halt.

For Wall Street it doesn’t matter what happens to these junk bonds and leveraged loans after they’ve been moved on to mutual funds where they can decompose sight-unseen. And it doesn’t matter to Wall Street what happens to leverage loans after they’ve been repackaged into highly rated Collateralized Loan Obligations that are then sold to others. CLOs are hot.

What matters are the fees.

But the oil bust tripped the banks up, and some of them have gotten stuck with their formerly hot leveraged loans that suddenly no one wants. Banks have been discounting them, and still, they’re having trouble unloading them. The Wall Street Journal cites an example:

The banks held off for several months, hoping that oil prices would rebound….

Instead, oil prices continued to plunge.

In March, the banks decided to cut their losses and approached hedge funds that specialize in distressed debt about buying a smaller $1.05 billion loan, people familiar with the matter said. The banks offered the C&J loan at about 85 cents on the dollar this week.

If they sell the entire loan at that price, they will raise about $893 million, leaving a funding gap of $157 million.

About half of the shortfall would be offset by fees and wiggle room the banks prenegotiated with C&J, leaving the banks with a loss of about $80 million….

The Fed and the OCC have been warning banks about the risks of leveraged loans for two years. In July last year, Fed Chair Janet Yellen herself warned about them publicly. Regulators have reason to be worried: Banks had gotten stuck with about $150 billion in leveraged loans before the Financial Crisis and lost their shirt on them. Retail investors with loan mutual funds, where these things tend to end up, are supposed to take the losses, not banks.

And the losses are piling up as the series of defaults and bankruptcies continued with the bankruptcy filing of major natural gas producer Quicksilver Resources on March 17. Samson Resources, an even larger natural gas producer, seems to be headed that way too [read… Investors Crushed as US Natural Gas Drillers Blow Up].

Also on March 17, global energy engineering contractor Willbros Group, out of Houston, disclosed in an SEC filing that it is in deep trouble, which caused its already battered stock to plunge over 50% in minutes. The stock closed on Friday at $3.07. Class-action lawyers are circling.

The company isn’t small fry: it had over $2 billion in revenues in 2013. But now it talked about the “downturn in energy prices” and the “challenging conditions.” It offered a laundry list of action to help it survive: cost reductions, asset sales, and actions to “reformulate” its oil and gas segment to come up with “a leaner and more reliable business model.” A big priority would be the “preservation of liquidity.”

The company faces credit defaults. It needs waivers from its lenders by the end of March. And it raised doubts about its “ability to continue as a going concern.” A phrase that put the disconcerting possibility of bankruptcy in view.

Then on March 20, Saratoga Resources, a Texas-based oil-and-gas exploration and production company with properties in south Louisiana, announced that it had hired restructuring advisors, an official admission that bankruptcy is being contemplated. It also appointed an interim CFO and a “strategic alternatives officer” – both from the restructuring firm – with a view to “achieving a satisfactory restructuring or repayment of the senior debt.”

Senior debt! Translation: holders of senior debt will get much of the company or the assets; holders of junior debt may get some leftover crumbs; stockholders will be wiped out. This is what happens after years on the cash-flow-negative treadmill.

There had been warnings. The company had missed two interest payments totaling $9.2 million, due at the end of last year, on its junk bonds. The forbearance agreements executed at the time by the note holders have now been extended to April 30, and the company will not have to make interest payments until that date. Quicksilver Resources too had a grace period after missing an interest payment, and when that grace period expired, it skidded into bankruptcy.

Saratoga’s senior secured notes due July 2016 traded between 19 and 20 cents on the dollar, according to LCD. The junior notes were quoted at 8 cents on the dollar. Shares closed at 21 cents on Friday.

Investors in these companies are being bled. But Wall Street banks won’t have to surrender the $31 billion in fees they extracted over the past five years. This is the beauty of the system. The Fed’s interest-rate repression and apparent guarantees that risks no longer exist, and that assets, no matter how inflated, can no longer decline in price, created the greatest credit bubble in history and lulled investors into closing their eyes. Many of these investors are fund managers that then shuffle off their products to largely unwitting Americans who’re trying to squirrel money away for their retirement.

The Wall Street Banks that did the financial engineering behind the oil boom, and provided the grease for it, will lose billions in fee income, and they’ll take a licking on leveraged loans that they got stuck with. But they’ll get through it. And they’re already busy figuring out other avenues to extract fees from the energy sector and its investors.

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Wolf,
Continued excellent reporting/commentary on the oil boom/bust in the US. From your research and figures, it seems clear that a goodly portion of this sector was never really economically sound.
I see eerie parallels with subprime. In that case, I do believe the financial industry believed they had received a “hall pass” to juice the economy. In otherwords, word came down from the very top (Bush moron) and through the big Wall Street firms doing “Gods’ work” that this was an area that the regulators would look the other way on. The rest is history.
I wonder if this same approach was used for fracking. A green light from the top and the rest will be history.

The difference will be the playout of the end game. If oil prices stay down and the industry goes from a knife wound to full hemorage the Fed will be under close scrutiny if a bailout is proposed. Still, I do believe some overall crisis is coming this year so adding in the frackers to a big bailout might be the least of everyone’s worries.

Julian the Apostate

Mar 23, 2015 at 6:07 am

Debt surely is a seducer. The car dealership I worked for in the ’70s was founded by an imigrant who arrived in the US with 67 cents in his pocket. He operated on a cash basis initially as a Hudson dealer, and moved on to Chevrolet. He took on a junior partner and they thrived, by the time he died in 1969, the company owned a good chunk of downtown Omaha. I hired on in 1978, working for the junior partner and the founder’s sons. When the old man retired the company made the decision to build an office tower with borrowed money. Upon hearing this the old man reportedly said he would never set foot in the building, and never did. The dealership is gone now, torn down several years ago.

Vespa P200E

Mar 23, 2015 at 12:36 pm

Yield hungry investors small and big have piled onto the junk bonds in the ZIRP and perhaps soon NIRP environment (as seen in Europe). Alas the string of highly leveraged bond bets defaulting just may be the start of unwinding of toxic derivatives CDS which means that there will be bagholders as there is no dumb AIG to pay off the CDS bets. This won’t be the black swan moment per say but the lemmings on the street didn’t think Bear Stearns and Lehman would go belly up too.